Topic 6: Federal Housing Policy – Income Tax Issues

(Suggested textbook reading: Chapter 8 and Chapter 16)

The federal government takes steps to keep housing affordable and home values stable. [Is this an appropriate use of government power and resources?] It does so through various policies, including tax breaks for home owners and subsidies to those who build or occupy low-income housing. For these purposes generally a “home” can be any dwelling place, including a boat or mobile home, that has sleeping quarters and bathroom & cooking facilities.

I. Federal Income Tax Policy

As we noted earlier, mortgage loan interest and property tax payments are deductible from income for federal income tax purposes. In other words, households are taxed on “income,” but that income measure is an adjusted income that reflects the subtraction of certain expenses.

A. The basic equation for federal income tax computation is:

·  Gross Income (other than excludable items, such as mtg. debt forgiveness)

The dollar amount of debt that is not repaid generally counts as taxable income (there can be exceptions). But the Mortgage Forgiveness Debt Relief Act of 2007 allowed someone to exclude from income, for income tax computation, cancellation of up to $1 million ($2 million for joint return filers) of debt that was obtained to buy/build/improve a principal residence, or refinancing of such debt. Debt cancellation could come through a loan restructuring or a “short sale.” So if someone owed $260,000 on a house they could sell for only $200,000 and the bank approved a short sale (perhaps to avoid the even bigger headaches of foreclosing) the $60,000 in forgiven debt was not taxed as income to the borrower. The law was enacted for the 2007 tax year and extended each year through the end of 2016, when it was set to expire for good. But a bill proposing a Mortgage Forgiveness Debt Relief Act of 2017 to make the benefit permanent was introduced in Congress in early 2017.

Also, unlike with stocks and bonds sold for prices exceeding the original purchase prices, a married couple that sells a home for more than was paid can exclude up to $500,000 of the excess (singles or married people filing separate returns can exclude up to $250,000) from income (they do not have to pay income tax on this capital gain).

·  Minus Adjustments

·  Equals Adjusted Gross Income

·  Minus Deductions

[Home mortgage loan interest (deductible since 1913, currently on debt of up to $1,100,000 secured by a first and/or second residence – true for a married couple or a single individual, such that unmarried co-owners of one or two homes can deduct interest on up to $2.2 million), ad-valorem local property tax, mortgage insurance (FHA, PMI), discount points on a new mortgage loan, state income tax, charitable contributions, very high medical expenses, very high employee expenses. Interest paid on a first or second home can be deducted from AGI, but only if the mortgage is recorded at the local courthouse. Penalties the lender charges for a late payment, or for prepayment, count as deductible interest. (Interest the home seller pays on the day when the property is sold cannot be deducted.)

One or more discount points (a “point” is 1% of the loan amount) may be charged by the lender to increase the lender’s effective periodic rate of return in connection with a new mortgage loan, often as a tradeoff for quoting a lower periodic interest rate. Points on a loan to buy or build a principal residence usually are fully deductible by the borrower in the year paid – even if the property seller pays the points on the borrower’s behalf!! (Points paid by a home seller for a buyer/borrower reduce the buyer’s basis in the home, which could under some circumstances result in a taxable gain when the buyer later sells.) To be deductible, the points charged must be reasonable relative to points charged on similar loans in the local community.

Points must be amortized over the loan’s life if they are wrapped into the amount borrowed, they are paid on a loan for a second home, or the borrower is refinancing an existing loan (a refinancer who borrows extra money to improve the home can deduct the points paid on the excess). Points are not deductible if they cover specific loan costs, like appraisal or title search fees, that normally are shown as specific dollar-based costs for a borrower (and the IRS is wise to the possible ruse of paying more in “deductible” points in return for not paying appraisal or title fees). So they must be classified as a general loan origination cost in the loan documents, and IRS form 1098 must be provided by the lender to document how much in points the borrower paid in the year the loan was obtained.

A standard deduction of $12,600 for married couples filing jointly applies to 2016 returns. So if your total of expenses in these areas does not exceed $12,600 (half that amount for singles), it makes no sense to itemize, and you get no marginal income tax benefit from your mortgage loan interest, mortgage insurance, and property tax. And then, just to make it a little more complicated, for a few years Congress allowed a household that pays property tax on an owned principal residence to claim the regular standard deduction plus an extra amount up to $1,000, but this provision seems to have expired after the 2009 tax year.

·  Minus Personal Exemptions ($4,050/family member for 2016 returns)

·  Equals Taxable Income

·  Times Average Tax Rate

·  Equals Tax Owed

·  Minus Credits

·  Equals Final Tax Liability

[This equation shows the conceptual technique for computing federal income taxes;

the step-by-step procedure on IRS tax forms is slightly different.]

Many of the credits that can reduce individuals’ income taxes relate to caring for dependent children or paying college tuition. But the Energy Policy Act of 2005 reinstated the 1970s idea of “residential energy credits.” A home (house, condo, even houseboat or trailer) owner can claim credits (typically not more than $500 total during the years you own for smaller energy improvements, but $2,000 for big things like solar heating or hot water systems) for enhancing home energy efficiency through solar/ photovoltaic/geothermal heat systems, air conditioning, windows, water heaters, insulation and caulking, and even fans. But these credits reduce the home’s tax basis, so in extreme cases they could lead to capital gain taxes later. Also, low-income home owners may get credit instead of/in addition to deduction for mortgage loan interest paid.

A low-income taxpayer that obtains a Mortgage Credit Certificate from a state or local government housing agency can qualify for a federal income tax credit for mortgage loan interest paid. The credit is based on interest paid on a qualifying portion of the debt, and interest amounts applied toward the credit must be excluded from any amount shown as an itemized deduction. If the credit exceeds the amount owed as taxes the difference can be carried forward for up to three years.

A controversial credit instituted as part of the 2009 federal economic stimulus package was a federal income tax credit for first-time home buyers of 10% of the home’s purchase price (maximum of $4,000 for single filers, $8,000 for married couples, so the credit will be $4,000 or $8,000 unless the price is really low). This credit originally was scheduled to terminate on November 30, 2009, but Congress then extended the credit until April 30, 2010 – and added a 10% credit for existing home owners who bought replacement homes (maximum of $3,250 for single filers, $6,500 for married couples).

For either credit an individual buyer’s income could be no higher than $125,000 ($250,000 for married couples), the home could cost no more than $800,000, the home could not be bought from a relative, and the credit had to be repaid if the home was not used as the claimant’s principal residence for at least the subsequent three years. A “first-time” home buyer generally was considered someone who had not owned a home in the previous three years.

While this credit no longer exists, it is interesting to discuss here. First, it shows the type of short-term boost that lawmakers sometimes try to give housing (President Bush #41 proposed something similar in about 1990, but Congress would not pass it). Second, some observers felt people accelerated planned home purchases to meet the April 2010 deadline, thereby merely displacing sales that otherwise would have taken place later.

Note: income tax laws are subject to frequent change, and there are limits on some of the provisions listed above. For example, itemized deductions and the personal exemption are phased out at higher income levels, and the ability to deduct mortgage insurance was slated to expire after 2010, but did not (originated for one year with 2006 Tax Relief & Health Care Act, was extended through 2007 Mortgage Forgiveness & Debt Relief Act). Current federal income tax law also allows a first-time home buyer who has had an IRA for at least 5 years to make a tax-free withdrawal of up to $10,000 toward the purchase.

B. The “cost of housing” equation

Case 1: Home is 100% financed

The text offers this equation: C = [(1 – t)(i + p) + m + (d – f)] P [Equation 1]

for which C = annual dollar cost of owning a house instead of renting

t = marginal federal income tax rate

i = interest rate on mortgage loan p = effective property tax rate

m = annual differential maintenance outlay as a % of value (i.e., what an owner would face but a renter would not)

d = annual depreciation as a % of value

f = inflation rate that applies to housing

P = price paid for the house

Let’s say that the owner paid $200,000 for the house (= P). Also assume that t = 28%,

i = 10%, p = 2%, m = 1%, d = f.

So C = [(1 – .28)(.10 + .02) + .01 + 0] x $200,000

= [(.72)(.12) + .01] = $19,280

We would compare this figure with the annual cost of renting a similar housing unit, and choose the option that is cheaper.

But is that the whole story? This approach may be a little simplistic, in that it requires the home value to equal the loan amount; note that in Equation 1 we could factor out the term (1 – t)(i)(P), meaning that we treat the purchase price as being 100% financed.

Case 2: 20% Down-Payment, interest rates on borrowing and saving equal

If part of the buyer’s money were tied up in a down payment, on which interest were

being lost, would our cost computation be affected? It depends. If we can earn the same rate on savings that we pay on the loan, notice what happens:

a. If we borrow the whole $200,000, we pay $20,000 in interest but get a $5,600 income tax savings, so net interest cost is $14,400.

b. If we borrow only $160,000 (20% down payment),

·  we pay $16,000 in interest, but get an income tax savings of (.28 x $16,000) = $4,480, so net cost of interest paid is ($16,000 – $4,480) = $11,520.

·  we also lose $4,000 of interest on the $40,000 down-payment. But that’s also $4,000 of income that we don’t have to pay income tax on, so we save ($4,000 x .28) = $1,120 in income tax. So net cost of interest given up is ($4,000 – $1,120) = $2,880.

Net cost of interest, if we borrow $160,000, thus is $11,520 + $2,880 = $14,400.

Other costs/benefits would be the same in either case: (.02 x .72 x $200,000 for property tax and .01 x $200,000 for maintenance; total of $4,880). So the grand total is $14,400 + $4,880 = $19,280, the same total that we computed above.

Case 3: 20% Down-Payment, interest rate on borrowing exceeds rate on saving

Of course, it is more likely that we would have to deal with two different interest rates, because an individual’s borrowing and lending interest rates are not equal (i.e., the capital markets are not perfect). The equation now would be:

C = [L/V (1 – t) iL + (1 – L/V)(1 – t) iS + (1 – t) p + m + (d – f)] P [Eqn. 2]

for which L/V = loan-to-value ratio (% of home value borrowed),

iL = interest rate paid on the mortgage loan

iS = interest rate given up by taking down-payment out of savings

Let’s assume a loan-to-value ratio of 80% (so there is a 20% down payment), a loan interest rate of 10%, and a savings interest rate of 5%. [Here we treat purchase price P and the home’s appraised value V (value the lender considers when setting loan terms) as equal, but it would be possible for P to exceed V if the buyer overpaid.] Cost now is

C = [.8(1 – .28)(.10) + .2(1 – .28) (.05) + (1 – .28)(.02) + .01 + 0] x $200,000

= (.0576 + .0072 + .0144 + .01) x $200,000 = $17,840.

This is a lower cost than we computed before. Why? Because we are no longer assuming that your $40,000 savings balance would earn a high rate of interest. (The idea is that if you can’t earn a high rate of interest on your savings dollars, you might

be better off putting the money into your housing purchase, and borrowing less.)

Case 4: Different income tax rates on borrowing, saving

Is there anything else to consider? One question is whether you pay tax on interest earned at the same rate that you save tax on interest paid. In Illinois, you do not. Why? The tax base for Illinois state income tax is the adjusted gross income from your federal income tax return. That figure includes interest that you earn, but not mortgage loan interest that you pay. (You do get a slight state income tax break for property tax paid; we will approximate that break by treating it as a deduction even though the break actually comes in the form of a state income tax credit.)

So let’s restate our cost equation as

C = [L/V (1 – tF) iL + (1 – L/V)(1 – tSF) iS + (1 – tSF) p + m + (d – f)] P [Eq. 3]